Q2 2017 Macroeconomic Overview and Outlook

We started the year with cautious optimism, and most of the risks we saw at the time abated during the second quarter. This led to equities outperforming fixed income. The second quarter of 2017 saw continued growth in the global economy. Global purchasing managers’ indexes (PMIs) continue to reach new highs, and although U.S. PMIs haven fallen from their peaks, they are still indicating positive growth in the economy.

Global earnings improved across both countries and sectors, while political risks abated in Europe. The French election saw a pro-Europe, pro-euro and business-friendly candidate become the youngest president in France’s history. On the other side of the English Channel, it did not work out as well for Theresa May, who lost her majority government, making the Brexit negotiations more difficult and complex. We believe the negative economic impact will be mostly contained in the U.K.

We continue to have a heightened focus on the potential actions of fiscal and monetary policy-makers. Increased fiscal spending and tax cuts remain a priority for President Trump, but the timing of any policy implementation may not be until 2018. Meanwhile, the U.S. Federal Reserve remains key to central bank moves around the world, and we expect continued U.S. rate hikes and an ongoing reduction in monetary stimulus. More recently, various central banks have communicated plans to raise rates.

Canada

Capital Market Review

Canadian equities, as measured by the S&P/TSX Composite Index, declined 1.6% during the second quarter. Falling commodity prices led to an outsized decline of the energy and materials sectors, while the largest sector in the index, financials, also declined amid investor concern about Canadians’ elevated indebtedness in the face of rising rates.

A reassessment of future global monetary policy actions, including the Bank of Canada, contributed to a material increase in Government of Canada bond yields during the last few weeks of the second quarter. Domestic fixed income, as measured by the FTSE TMX Canada Universe Bond Index, but declined 1.1% in June, although it was up 1.1% overall for the quarter. While Government of Canada bonds experienced the most significant drawdown toward the end of the quarter, provincial and corporate issues offered some protection with better returns.

Economy

Canada’s GDP continued to grow, with 3.7% annualized growth in the first quarter of the year. A rebound for business investment made a significant positive contribution to growth as the oil and gas industry continued its recovery. Consumer spending remained supportive of economic expansion, more than offsetting weakness from Canada’s exports.

Inflation

At 1.3% in the 12 months through May, headline inflation, measured by the consumer price index (CPI), fell back toward the lower end of the Bank of Canada’s 1% to 3% target range. Core inflation, as defined by the Bank of Canada, rose only 0.9% over the same period, as it does not include gasoline prices, which were higher in May.

Interest Rates

During two official announcements, the Bank of Canada retained the target for its overnight lending rate at 0.5%; however, official comments from members of the bank’s Board of Directors contributed to investors’ growing perception that rate increases would be likely after the quarter ended. These perceptions became reality on July 12 when the bank increased the overnight rate by 25 basis points to 0.75%.

Economic Outlook

Recent rhetoric from the Bank of Canada suggests the Canadian economy is set to achieve sustainable growth, with inflation migrating toward 2%, and the output gap, which measures the amount of spare capacity in the economy, closing sooner than previously expected. This change in expectation is supported by Canada’s oil and gas sector adjusting to lower oil prices. Continuing strength in the labour market, which in turn helps maintain consumer spending, is also viewed as positive for the domestic economy.

While the outlook is considered more positive than earlier this year, downside risks stemming from the high level of consumer debt and a lack of robust wage growth could undercut domestic demand. Although energy companies are now better positioned to deal with lower oil prices, a further decline would place further downward pressure on business investment.

Canadian Equity Outlook

The outlook for Canadian equities remains largely dependent on the performance of commodities, domestic bank profitability and the strength of the Canadian dollar.

The future direction of oil prices is expected to remain range bound, and with ample supply remaining available, a further price decline is a downside risk that we continue to monitor. Regulatory changes from the Ontario government are expected to slow future house price appreciation; however, the current high value of housing and the correspondingly elevated level of consumer debt present investors with the perception that the future profitability of Canada’s banks could potentially decline.

Fixed Income Outlook

As expected, interest rate volatility has been elevated throughout the first half of 2017. As investors position for a potential change in global monetary policy, continued fluctuation will remain high for the foreseeable future. Even with this bumpy path, Government of Canada bond yields are expected to migrate to modestly higher levels. The additional income provided by corporate bonds will support their outperformance.

United States

The U.S. economy continues to grow at a tepid pace, as evidenced by the 1.4% annualized real GDP growth rate in the first quarter of 2017. Expectations for the full year remain soft, with economists predicting real GDP growth of just 2.2% in 2017 and 2.3% in 2018. The S&P 500 increased only 0.39% in Canadian dollar terms) in the second quarter and 3.09% in local terms as the Canadian dollar increased relative to the U.S. dollar across the second quarter.

The second quarter was solid for U.S. equities in local terms; however, the strength of the Canadian dollar wiped out most of those gains. After three years of weak earnings growth in the benchmark S&P 500 Index, analysts are predicting earnings growth of 10.2% by the end of this year and 11.6% in 2018. The primary driver of U.S. equity returns over the past three years has come from investors willing to pay for future earning potential, and so earnings growth is now critical for future gains. The S&P 500 is trading at 18.5 times 2017 earnings, which is expensive relative to historical valuations. A price-to-earnings ratio of 18.5 means investors pay $18.50 for every $1 in earnings per share.

At its June meeting, the Federal Reserve raised the target federal funds rate by 0.25 basis points to the 1.0%-1.25% range. The decision to increase interest rates was not surprising, and the Fed indicated it was on the path to increase rates one more time in 2017. The most important news to come out of the June meeting was a more detailed plan by the Fed to begin to reduce monetary stimulus by reducing its $4.5-trillion balance sheet by the end of 2017.

The Canadian dollar rose 2.72% relative to the U.S. dollar in the second quarter to $0.77128 CAD/USD. The biggest sector winners in the second quarter were health care (+4.28%), industrials (+2.05%) and financials (1.54%). On the flip side, the worst-performing sectors in the second quarter were telecom (-9.48%) and energy (-8.83%).

Outlook

After eight years of a bull market, U.S. equity valuations are far from cheap, but growth in earnings is finally beginning to be realized. If analysts’ expectations for earnings growth are accurate, and low double‑digit gains in profits are achieved over 2017 and 2018, then a high single‑digit total return is very possible over the next 12 months. Further gains from expanding price-to-earnings ratios are unlikely going forward, with the Federal Reserve entering a period of tightening monetary policy, so the focus is squarely on U.S. corporations delivering earnings growth.

Europe

Capital Markets

European equities gained in the second quarter. The Morgan Stanley Capital International (MSCI) Europe Index returned 2.1% (total return in local terms). The strength of European currencies, particularly the euro, added further to returns, with European equities up 4.9% in Canadian dollar terms.

Economy

The European Union economy expanded in real terms by 0.6% (not annualized) in the second quarter. Economic activity indicators remain strong, suggesting the recent economic growth should continue. Labour markets continue to strengthen, with the unemployment rate for the EU falling to 7.8% (9.3% for the eurozone). Eurozone inflation moderated in the quarter and remains below target, at 1.3%. U.K. inflation is trending higher as a result of declines in the pound following the U.K.’s Brexit decision to leave the EU.

Key Developments

Politics remain at the forefront. In France, Emmanuel Macron, a pro-European centrist, was elected president. A centrist, pro-European government with a reform agenda is a positive development for Europe given France’s importance. In the U.K., the Conservative government’s early election gambit to increase its majority backfired. The Conservatives ended up losing their majority government, forcing them into a coalition government with a small Northern Ireland party. A weak government mandate could complicate Brexit negotiations.

Outlook

European economies continue to strengthen in general, and economic indicators suggest growth should continue. However, the surprising strength seen in Europe has led markets to question the European Central Bank’s commitment to exceptionally accommodative monetary policy. As inflation remained subdued, normalization in monetary policy should progress more slowly relative to other markets. Economic strength and improving corporate profitability is supportive for European equities. However, risks remain elevated, with Italy remaining one of the key areas for potential volatility.

Sources: The returns quoted in capital markets are from FactSet. The currency return impact is geometric. Economic statistics quoted (GDP, inflation, unemployment rate) are from Eurostat.

Emerging Markets

The MSCI Emerging Markets Index gained 3.6% in Canadian dollar terms during the second quarter, moderately outperformed developed-market equities. On the growth front, China’s GDP grew 6.9% in the first quarter, continuing to show signs of stabilization. However, second-quarter high‑frequency data like PMIs, rail passenger volumes and electricity consumption showed slower expansion. In Brazil, while the market was spooked by new bribery charges against President Michel Temer, moderate economic expansion in Brazil is still ongoing. Across various emerging markets , inflation has been tamed, likely because of generally more tepid economic activities. In India, the economic output gap is widening. Russia’s high‑frequency economic data has also shown some signs of slowdown, given the more complicated global energy outlook.

Outlook

Going forward, the relative strength of emerging markets since last year is likely to come to an end. The U.S. Federal Reserve’s monetary policy normalization has caused central banks in emerging markets to lean toward a neutral rather than dovish stance. China has recently re-emphasized its plan to deleverage and tame liquidity in the market, showing no intension to push the economic growth rate higher. On geopolitical front, Qatar’s ongoing tension with other oil‑producing countries could add uncertainty to the energy market. The Chinese Communist Party’s power transition later this year as well as North Korea’s military ambitions could result in sharp changes in sentiment, hurting riskier assets.

Commodities

Commodity prices continued to retreat in the second quarter, with the S&P Goldman Sachs Commodity Spot Price Index down 4.1% over the quarter. Oil prices led the decline, with Brent crude down 9.8%, while Western Canadian Select and West Texas Immediate crude oil both dropped by 10.9% over the quarter as global supply continued to outstrip demand. After rising in the first quarter, gold spot prices declined slightly, down 1.2%, while silver prices dropped 9.6%. On an aggregate basis, material prices were relatively unchanged over the quarter, while agriculture and livestock prices climbed by 2.9% and 8.7% respectively.

Portfolio Positioning

We increased our position in equities versus fixed income to neutral-to-overweight. While global macroeconomic conditions remain neutral, financial market conditions continue to be supportive for equities. Earnings continue to trend positively across developed markets, and global macroeconomic risk indicators remain low.

We further reduced our position in Canadian equities but remain neutral-underweight. Earnings sentiment remains weak relative to major indexes, oil is still well below a level profitable for Canadian producers, and Canadian banks have fallen in rank relative to those in the U.S. and Europe.

We maintain an overweight position in U.S. equities. Economic fundamentals remain strong compared with other regions. We are neutral-to-overweight in France. Political risks have subsided since Macron’s election and the economy, earnings and banks are improving. We are neutral-overweight Germany. The economy remains strong on a relative basis, with earnings improving. We are neutral-to-overweight Japan. The economy is structurally weak but cyclically strong, and equities are well supported by a weak currency.

We are neutral-to-underweight in U.K. holdings. Brexit will be drawn out and continues to drive uncertainty, creating higher inflation in a low‑growth environment. We are neutral-to-underweight Switzerland, given its market concentration in financial services with a defensive tilt. Switzerland is unlikely to outperform if global growth continues, and banks have weaker earnings. We are neutral-to-underweight Australia, which is exposed to the slowdown in China and the moderating demand for commodities.

We maintain a neutral position in Canadian short- and mid-term bonds. We continue to see modest upward pressure of interest rates around the world and especially from the United States. We also reduced our weight in Canadian long-term bonds. The portfolios remain underweight in cash.

Conclusion

The U.S. economy remains a key focus given its importance to the global economy. Whether any slowdown in U.S. growth can be offset by European strength will be a key factor for equity performance for the rest of the year. We also maintain a keen focus on monetary policymakers, as they look to remove stimulus and on fiscal policy-makers, particularly in the U.S.. Overall, we continue to recommend investors maintain an investment strategy that features diversification and active management aligned with their time horizon for investing.